Few aspects of regulating Wall Street are more fundamental than those requiring that public customers get the best execution for their orders, particularly when the customers' orders and those of their brokerage firm are competing to get filled at the best price. The simplest way to envision this so-called trading ahead scenario is to imagine that a public customer and her broker-dealer arrive at the exact same time before the exact same door, which is only wide enough for one at a time to fit through. When that narrow opening presents itself, the default regulatory protocol is for the broker-dealer to politely step aside and graciously say "after you." Most of the time, that's what happens. Sometimes, it doesn't. When it doesn't, there are rule exemptions permitting a broker-dealer to get out of line, elbow the customer aside, and bolt through the door. As you might imagine, when such discourtesy occurs in the trading line, Wall Street's regulators don't simply accept any old excuse. If a broker-dealer wants to cite an exemption for cutting in line, the regulators want proof that the trading ahead of a customer satisfied the requirements set forth in the exemption. In a recent FINRA regulatory settlement, we see what happens when a broker-dealer cuts in front of the trading line but can't satisfy the terms of the exemption.
Case In Point
For the purpose of proposing a settlement of rule violations alleged by the Financial Industry Regulatory Authority ("FINRA"), without admitting or denying the findings, prior to a regulatory hearing, and without an adjudication of any issue, Stifel, Nicolaus & Company, Inc. submitted a Letter of Acceptance, Waiver and Consent ("AWC"), which FINRA accepted. In the Matter of Stifel, Nicolaus & Company, Inc., Respondent (AWC 2014042512701 January 26, 2018).
The AWC asserts that Stifel, Nicolaus & Company, Inc. has been a FINRA member firm since 1936, and that the firm has the following "Relevant Disciplinary History":
On December 20, 2013, FINRA accepted an AWC to resolve four consolidated market order protection sweeps that covered different review periods, in which the firm was censured and fined a total of $80,000 for violations of National Association of Securities Dealers ("NASD") Rules 2111 (currently FINRA Rule 5320) and 2320, and FINRA Rule 2010. The AWC identified, inter alia, 27,641 trading ahead violations and restitution in the amount of $4,416.74.
The AWC alleges that in 18 instances between April 2014 to June 2014, Stifel had
accepted and held 12 customer orders in OTC securities;
traded for its own account at prices that would have satisfied the customer orders; and
failed to execute or immediately execute the customer orders up to the size and at the same price at which it traded for its own account or at a better price.
As set forth in the bullet-points above, we have the components of what is generally characterized by Wall Street regulators as "trading ahead." The regulators take the position that if a brokerage firm has customer orders, the firm should give the best execution available to a customer before the firm inserts itself between the customer's order and the best available price. In more precise terms, consider FINRA's applicable rule, which states in pertinent part:
FINRA Rule 5320: Prohibition Against Trading Ahead of Customer Orders
(a) Except as provided herein, a member that accepts and holds an order in an equity security from its own customer or a customer of another broker-dealer without immediately executing the order is prohibited from trading that security on the same side of the market for its own account at a price that would satisfy the customer order, unless it immediately thereafter executes the customer order up to the size and at the same or better price at which it traded for its own account.
(b) A member must have a written methodology in place governing the execution and priority of all pending orders that is consistent with the requirements of this Rule and Rule 5310. A member also must ensure that this methodology is consistently applied.
*** Supplementary Material:
. . .
.02 No-Knowledge Exception
. . .
(b) With respect to OTC equity securities, as defined in Rule 6420, if a member implements and utilizes an effective system of internal controls, such as appropriate information barriers, that operate to prevent a non-market-making trading unit from obtaining knowledge of customer orders held by a separate trading unit, the non-market-making trading unit trading in a proprietary capacity may continue to trade at prices that would satisfy the customer orders held by the separate trading unit.
(c) If a member implements and utilizes appropriate information barriers in reliance on this exception, the member must uniquely identify such information barriers as prescribed in Rule 7440(b)(19).
Peek-a-boo, I See You
As best I understand the genesis of the FINRA settlement, when the self-regulatory-organization confronted Stifel with the 18 instances between April 2014 to June 2014 when Stife traded ahead of 12 customer orders, the firm asserted its reliance upon FINRA Rule 5320 "No-Knowledge Exception" as set forth in the Supplementary Material .02(b). FINRA did not find that Stifel's conduct complied with the exemptive conditions.
In considering Stifel's exemption claim and the facts of the disputed transactions, FINRA concluded that "traders at one desk had the ability to view the outstanding customer orders that were accepted and held by another desk." The existence of such desk-to-desk transparency meant that Stifel did not have in place an effective system to prevent a non-market-making trading unit from obtaining knowledge of customer orders held by a separate trading unit. Accordingly, FINRA rejected Stifel's "No Knowledge Exemption," and deemed that the member firm traded-ahead in violation of FINRA Rules 5320 and 2010.
Additionally, the AWC alleges that during the second and the fourth quarters of 2014, and thereafter through the first quarter of 2015, Stifel's supervisory system did not have policies or procedures that erected and maintained effective information barriers between its desks. Also, FINRA found that the firm's written supervisory procedures failed to include a supervisory review that ensured that the firm's information barriers were operating appropriately.
Although the Stifel AWC is generally well written and replete with commendable content and context, I must admit to finding the wording of this allegation a tad awkward:
The firm's written supervisory procedures failed to
include a supervisory review that ensured that . . . (b) permissions that the firm's employees had to the firm's systems were granted
appropriately. . .
As best as I can decipher the above excerpt, FINRA found that Stifel's written supervisory procedures failed to ensure that its employees were appropriately granted permissions (hey, it's FINRA's word "permissions" not mine). Next we have to figure out what exactly these permissions were for, which seems to have something to do with the "firm's systems." Frankly, this portion of the AWC sounds like something Yoda would have written. Free you feel should to the line step and own shot you take at this interpret language of regulator self FINRA.
Additionally, the AWC alleges that although Stifel had a trading-ahead exception report, the firm failed to capture any of the trading-ahead instances identified by FINRA's staff; and the exception report was also flawed and unreliable.
FINRA deemed Stifel cited supervisory conduct to constitute a violation of NASD Rule 3010 and FINRA Rules 3110 and 2010.
Finally, during during the second and the fourth quarters of 2014, and thereafter through the first quarter of 2015, and, thereafter, in the fourth quarter of 2015, the AWC alleges that Stifel failed to report an information arrier identifier with its Order Audit Trail System ("OATS") submissions for 76 orders.
FINRA deemed Stifel's cited OATS conduct to constitute violations of FINRA Rule 7440(b)(19).2.3
In accordance with the terms of the AWC, FINRA imposed upon Stifel a Censure; a total fine of $37,500 comprised of : $20,000 for the trading ahead violations; $12,500 for the supervision violations; and $5,000 for the information barrier identifier violations); and $318.25 restitution to investors.